by Edwin M. Truman, Peterson Institute for International Economics
Paper prepared for the Chinese Academy of Social Sciences Conference "Marking the 30th Anniversary of the Reform and Opening-up", Beijing, China
December 16-17, 2008
© Peterson Institute for International Economics
Over the past decade, China has emerged as the largest holder of international reserves, a major international investor, and a substantial net creditor to the international financial system. In 2007, China created the China Investment Corporation (CIC) as a sovereign wealth fund (SWF) using a small portion of its international reserve assets. Many questions have been raised about the operation and management of the CIC and the nature of China's other international investments, including, importantly, China's international reserves. In what does China invest? Are the people of China receiving a good return on their investments? Is China using its investments to pursue political objectives? Should China be more accountable and transparent about its international investments?
In this paper, I review some of these issues and the associated challenges facing China as it emerges as a major player in the international financial system after three decades of wildly successful economic and financial development resulting from policies directed primarily at transforming China's domestic economy. I conclude that it is in the interests of China and the international financial system that China puts in place a higher degree of accountability for the management of China's international assets than is currently the case.
In the following section of this paper, I remind the reader of the history of China's reserve accumulation and some of the issues and challenges facing China and its partners. Next I look closely at China's record of accountability in the management of the international assets in the CIC and in China's National Social Security Fund (NSSF). I do so using the mechanism of my scoreboard for SWFs and the recently released Generally Accepted Principles and Practices for SWFs established by the International Working Group of SWFs. I then broaden my discussion to include other categories of foreign investment by the government of China: foreign exchange reserves managed by the State Administration of Foreign Exchange and government-owned financial and nonfinancial institutions. In the final section, I offer a few concluding observations.
China's International Assets
As of the end of September 2008, China's holdings of foreign exchange reserves were reported to be $1,905 billion. Including the international assets held by the CIC, the NSSF, and entities such as Shanghai Financial Holdings, a conservative estimate of China's holdings of international assets is more than $2 trillion, close to 50 percent of China's GDP measured in dollars and more than $1,500 per capita. The people of China have a considerable interest in how these investments are managed. For example, if the average, annual return on them could be boosted by 5 percentage points, say, by shifting them from holdings of US Treasury obligations to a broader range of financial assets, that would translate into an increase of about 2.5 percent in GDP per capita.
China's holdings of international assets have built up rapidly. Gross international assets more than doubled from year-end 2004 to year-end 2007 to reach $2.3 trillion, of which more than two-thirds were reserve assets managed by the government. (In contrast, the US government owns only 2 percent of the $17.6 trillion in US international assets.) Reserve assets accounted for more than 70 percent of the increase in China's international assets in 2007. From year-end 2004 to year-end 2007, China's international investment position rose from $293 billion to $1.0 trillion.
The rise in China's international reserves and investment position in recent years is a consequence of continuing large inflows of long-term capital, which increased by more than $450 billion from year-end 2004 to year-end 2007, and more recently of recorded short-term capital, reaching $380 billion at the end of 2007, and the explosive widening of China's current account surplus, which in October the International Monetary Fund (IMF) projected would reach almost 10 percent of GDP in 2008. Two months later, most forecasts are being recalibrated, but the basic trend has not changed.
China's current account surplus has continued to expand, and it is today the most significant global macroeconomic imbalance. The surplus is the consequence of the rapid transformation of China's economy under its dramatically successful policies of economic and financial reform over the past three decades interacting with an exchange rate policy that has been slow to react to the explosive growth of its current account surplus since the early years of this decade. The interpretation of these developments is controversial (Goldstein and Lardy 2008). My view is that these macroeconomic trends have been detrimental to the economic growth and stability of the Chinese economy as well as to the stability of the international financial system. However, that is not the topic for this paper.
What all can agree on is that China has a larger stock of international reserves than it needs at this point in its history. The people of China have a substantial interest in how those reserves, as well as China's other international assets, will be invested.
One approach is to try to use them to promote the economic development of China. However, that is easier said than done, as I have discussed elsewhere (Truman 2008b). If China wants to use its foreign exchange reserves to finance domestic investment or government expenditures, it must not only halt its accumulation of foreign reserves but also begin to repatriate some of the outstanding stock into domestic financial resources. Economic and financial policies—exchange rate as well as other macroeconomic policies—not only need to be recalibrated but also reversed in orientation in order to produce current account deficits and at the same time to sustain domestic production by boosting the growth rate of domestic demand.
China has indirectly tried to employ its foreign exchange reserves to support the domestic economy by using a small portion of them to fund the Central Huijin Investment Company in order to recapitalize Chinese banks and financial institutions. However, the foreign exchange resources subsequently have found their way back into China's reserve holdings, implicitly as the result of the provision of cover to the banks for the resulting foreign exchange risk and in due course through outright repurchases of the foreign exchange. Ultimately, it was the domestic liabilities of the People's Bank of China that were issued to sterilize these repurchases that financed the recapitalization of the financial institutions, not China's international reserves. The use of foreign exchange reserves was only an accounting detour.
A second approach to using China's foreign exchange reserves for development purposes is via funding the international activities of government-owned nonfinancial corporations or via direct government loans. Again, this so-called domestic use of China's reserves is merely a disguise. The government or the government-owned entity increases its demand for foreign exchange, and, in turn, that increase in demand for foreign exchange is satisfied indirectly by the People's Bank of China rather than directly in the foreign exchange market. Moreover, by using this less-than-transparent mechanism the government of China opens itself up to potential criticism of what appears at least in some cases to be politically motivated investment decisions and potentially a government subsidy.
One exception to this analysis is the use of China's international reserves to support the foreign currency operations of China's financial institutions if they were to lose access to international credit. However, this use of China's reserves is more closely analogous to the traditional use of a country's foreign exchange reserves for intervention in foreign exchange markets.
A third approach to resolving this dilemma of how to maximize the social return on China's foreign exchange holdings is to use them to establish an SWF to increase the risk-adjusted return on the external financial assets in the fund compared with the return from traditional foreign exchange holdings. This appears to be the rationale behind the establishment of the CIC in September 2007. The structure of the CIC involved combining this third approach with the continued use of the first approach via the Central Huijin Investment Company, which was, or is to be, absorbed by the CIC. As I have already argued, that approach is more about accounting than encouraging the productive use of China's foreign exchange reserves.
The international assets of the CIC are a tiny portion (less than 5 percent) of China's total foreign assets. However, because China is a rapidly emerging major player in the international economy and financial system, the activities of the CIC will be more closely scrutinized by the international community as well as by the citizens of China. The CIC will be held to the highest standard of accountability at home and abroad, and it should be.
A high level of accountability is a necessary but not sufficient condition for making the world safe for SWFs, including the CIC, as well as other official cross-border investments. Accountability has three dimensions: The first is accountability to the citizens of the home country. The second is accountability to the citizens of the host countries and their governments. And the third is accountability to participants in financial markets.
China's Sovereign Wealth Funds
As noted above, in 2003, China established what some might regard as an SWF in the form of the Central Huijin Investment Company. It was an SWF in the sense that a small portion of China's foreign exchange reserves were used to “finance” the entity even though its operations were essentially domestic in nature. (I use SWF as a descriptive term for a separate pool of assets, including some international assets, that is owned and managed directly or indirectly by governments to achieve a mixture of economic, financial, and political objectives.) When the CIC was established in 2007, Central Huijin became one of its subsidiaries or investment divisions. (Because CIC now includes international assets, I treat it as an SWF.) In addition, China's NSSF fits my definition of an SWF, although not all SWF definitions would cover the NSSF. The assets of Shanghai Financial Holdings are still small. China may have other SWFs of which outsiders are not aware.
How accountable are the two principal Chinese SWFs compared with the funds of other countries? In October 2007, I published a scoreboard [pdf] for SWFs, which included Central Huijin (Truman 2008b). The scoreboard included a number of elements (25 initially) grouped in four categories: structure, governance, accountability and transparency, and behavior. I required that at least one SWF embrace each element. In fact, for each element, a minimum of several funds do so. Central Huijin scored 6 points out of a maximum of 25 points, or 24 percent. This was in the bottom group of the 32 SWFs I examined.
In April 2008, I extended the scoreboard to include 33 elements for 46 SWFs including both the CIC and the NSSF (Truman 2008a). The CIC scored 29, again putting it in the bottom group of SWFs.1 On the other hand, the NSSF scored 77, in the top group of SWFs. This is interesting and informative for two reasons. First, on the basis of my scoreboard, the NSSF scored much higher than the CIC. Second, the 12 pension SWFs that I included in the revised scoreboard all scored in the top group, but they were joined by 10 nonpension SWFs. This suggests that the CIC, in principle, could score at least as well as the NSSF.
My blueprint for SWF best practices (Truman 2008a) was intended as an input to the IMF-facilitated process aimed at producing a voluntary standard for all SWFs. That process, the International Working Group of SWFs, in which China participated, resulted in the Generally Accepted Principles and Practices (GAPP) for SWFs (the Santiago Principles, IMF 2008), which were released on October 11, 2008.
The GAPP is a very respectable piece of work. The participants and the IMF should be congratulated for the content as well as the speed with which it was agreed. The GAPP also measures up reasonably well on my scoreboard. I have scored it at 74, including extra credit for some elements that are not part of my scoreboard.
How well do the CIC and the NSSF measure up against the standard of the GAPP? I have not done a full accounting, but a reasonable approximation is possible because 22 of the 30 principles and subprinciples in the GAPP overlap in whole or in part the 33 elements in my scoreboard. Therefore, one can look at the intersection of the GAPP with my scoreboard.2 On this basis, the CIC's score increases to 33, moving it into the middle group of funds, but not fundamentally altering its relative position. The NSSF's score increases only slightly to 79, with a very small decline in its relative position, though it remains in the top group.3
Thus, on the basis of either my scoreboard or the GAPP, the CIC appears to fall short with respect to accountability to China's citizens, to the citizens and officials of countries in which it invests, and to market participants generally. Some of the areas of shortfall include: lack of information on how the CIC's earnings are employed, decisions not made exclusively by managers (true of the NSSF as well), no systematic information published on the location of CIC investments (true in part of the NSSF), no annual report released to date, no audit released to date, no policy on the use of leverage publicly released (true of the NSSF as well), and no policy on the use of derivatives publicly released.
To be entirely fair, some of these shortfalls may be attributable to the fact that the CIC is a relatively young institution. Officials of the CIC have indicated that it will be releasing an annual report, but one has not yet been released. When and if the CIC releases an annual report, some of this missing information may be contained in it. Whatever the explanation, the CIC has a considerable way to go before reaching the highest international standard for SWFs, and the NSSF might reasonably be expected to consider whether it should seek a higher score as well.
China's Other Foreign Official Investments
The State Administration of Foreign Exchange (SAFE) holds a portfolio of international assets that is about 20 times the size of the CIC's international portfolio. It follows that citizens of China and the rest of the world should be more concerned about SAFE's investment activities than those of the CIC. In fact, the amount of systematic information about SAFE's assets is essentially zero aside from reports four times a year on China's total holdings of international reserves. This is an actual and potential problem for China and for the international community.
First, SAFE's assets are growing more rapidly than are those of the CIC. Second, there is an international standard for disclosure of reserve holdings, to which China does not adhere. Third, it is clear from periodic press reports that SAFE is increasingly active in managing its international reserves, including for political purposes in connection with investments in Costa Rica. SAFE's assets are not exclusively claims on foreign commercial banks or the governments of countries that issue currencies included in the basket used by the IMF to value special drawing rights (SDR).4
What international standard might be applied to SAFE? The answer is that China should strongly consider subscribing to the reserves template of the special data dissemination standard (SDDS) of the IMF. Sixty-five IMF members subscribe to the SDDS. In doing so, they commit themselves to the disclosure requirements of the reserves template. Those 65 countries include not only most advanced countries but also most other emerging-market countries. China and Saudi Arabia are the only countries that are members of the Group of Twenty (G-20) systemically important countries and that do not subscribe to the SDDS.
China may consider the full statistical requirements of the SDDS too onerous at this stage of its development, although much poorer countries such as India and the Kyrgyz Republic manage to subscribe to the SDDS. Moreover, one IMF member, New Zealand, abides by the standard of the reserves template while not subscribing to the SDDS.
Given the extent of China's official foreign exchange reserves, it is reasonable to presume that China does have the requisite information to meet the minimal standard of the reserves template. It was designed and adopted in 1999 in the wake of the Asian financial crisis. It requires countries to disclose at least monthly, with no more than a one-month lag, information, for example, on the foreign-currency assets differentiated by securities (domestic distinguished from foreign), deposits (in domestic banks distinguished from foreign banks), IMF reserve positions, gold, SDR, other reserve assets. The template also requires the reporting of certain potential drains on reserves as well as a limited amount of information on the currency composition of reserves, distinguishing holdings in the SDR basket currencies and in other currencies. Moreover, more than two dozen countries voluntarily disclose complete details on the currency composition of their reserves. (It is widely understood that China does not even report the currency composition of its reserves confidentially to the IMF as part of the Composition of Foreign Exchange Reserves [COFER] program. This policy should be reconsidered.) As it stands, the reserves template is not particularly demanding, and it should be expanded and updated in light of recent financial developments to provide more information on the types of assets in which countries now invest.
China should subscribe to the template, whether or not it is updated, to address the increasing suspicion that surrounds SAFE's management of China's foreign reserves. It is clear from press reports that SAFE in many respects is acting more like an SWF than as a traditional reserve manager.
In addition to the active management of China's foreign exchange reserves by SAFE, China is likely to face increasing scrutiny about the international operations of state-owned enterprises (SOEs), nonfinancial as well as financial. That scrutiny will focus on the (potentially subsidized) terms on which the SOEs obtain domestic- and foreign-currency credit, the nature of their investments including whether they are politically or strategically motivated, and implications of such investments for fair and open international competition. Again, it would be in the interests of China to devise means to allay some of these concerns principally by introducing greater accountability and transparency into the operations of the SOEs.
China's burgeoning international reserves, the active management of those reserves either directly or by the CIC or other SWFs or SWF-like entities, and the growing scale and scope of China's other international financial operations pose challenges for China, its partners, and the international financial community. Because of its size and importance in the world economy, including concerns, whether fair or not, about potential unfair competition, China should expect to be held to the highest standards of accountability in managing its international assets. To date, China's record has been deficient.
The CIC scores poorly on my scoreboard and the International Working Group's new GAPP for SWFs. The NSSF scores higher than the CIC, but not as high as most of its peers among pension SWFs. SAFE's management of China's foreign currency reserves is opaque. This is a particular problem in light of its increasingly active management practices. The same is true for some aspects of the international operations of China's SOEs such as the China Development Bank.
The citizens of China deserve greater accountability in the management of their assets. They need to be reassured that no corruption is involved, that the managers are highly professional, and that they seek to maximize risk-adjusted returns.
Although the management of China's international wealth is of principal interest to the citizens of China, it is also of interest to China's partners in the international financial system. At the same time, those partners should practice reciprocal responsibility by maintaining and enhancing the openness of their financial markets to investments by China and other countries. Absent such reciprocal responsibility, the world risks a serious outbreak of financial protectionism, which would be debilitating to the world economy and financial system, in particular given the system's delicate health at this time.
Reciprocal responsibility involves more than just the area of financial relations. It also involves an appropriate role for China in the international financial system, but that is a topic for another paper on another occasion.
IMF (International Monetary Fund). 2008. Sovereign Wealth Funds: Generally Accepted Principles and Practices. Washington.
Goldstein, Morris, and Nicholas Lardy, eds. 2008. Debating China's Exchange Rate Policy. Washington: Peterson Institute for International Economics.
Truman, Edwin M. 2008a. A Blueprint for Sovereign Wealth Fund Best Practices. Policy Briefs in International Economics 08-3 (April). Washington. Peterson Institute for International Economics.
Truman, Edwin M. 2008b. The Management of China's International Reserves: China and a Sovereign Wealth Fund Scoreboard [pdf]. In Debating China's Exchange Rate Policy, eds. Morris Goldstein and Nicholas Lardy. Washington: Peterson Institute for International Economics.
1. Using information available as of September 2008, the CIC's score would be 30.
2. Because the overlap is incomplete, the maximum number of points on the GAPP-based scoreboard is 20.
3. No SWF that was in the lowest group (blueprint score of less than 30) or middle group (blueprint score of less than 60 but more than 30) received a higher score than one that was in a higher group on my blueprint. The correlation of the two sets of scores is 0.98.
4. Those currencies are the euro, Japanese yen, UK pound sterling, and US dollar.
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